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What's Up with Risk?

In the investment industry, the term "risk" is often used to frame a point of view or compare and contrast different opportunities. Merriam-Webster defines the word as 1: possibility of loss or injury; 2: someone or something that creates or suggests a hazard; 3: the chance of loss or the perils to the subject matter of an insurance contract; and 4: the chance that an investment will lose value. The reality is that there are many definitions of risk; each of us defines it differently.

In finance, it is common to use the statistical concept of standard deviation to measure risk. Expected outcomes are expressed in graph form by a normally distributed curve. The center is the highest point along the curve and represents the expected average outcome with the greatest frequency. As one moves from the center, the line declines (expected frequency declines) as the variability increases from expected results.

We find that measuring risk by using standard deviation is a challenged exercise for investors. First and foremost, returns in financial markets are not normally distributed, a core tenet of the concept. In meteorology, it seems that various regions of the country experience 100-year floods once a decade. Similarly, market crashes, such as the one experienced during the financial crisis of 2007-2008, occur far more frequently than predicted by the model.

As rational individuals, we will not deliberately assume risk without expecting a corresponding reward. Under this framework, all investors should seek out investments that disproportionately reward for the risk that is assumed. Unfortunately, there is no such thing as a 'free lunch.' If you think you are getting something for nothing, then you are missing a key factor.

EPIQ's view of risk is more pragmatic. We assess the chances that we could suffer a true impairment to our capital and balance that with the expected return should future results evolve as we predict. We use this framework in analyzing broad market opportunities as well as individual positions.

Looking ahead, equities should provide the best risk/reward opportunity into the second half of 2017, followed by hard assets such as commodities and real estate. We see fixed-income offering the least attractive prospects. The economic and social conditions underlying the US and other global, developed economies continue to support entrepreneurial innovation in the private sector. This central condition permeates virtually all sectors of the economy, which results in productivity gains. This increase in productivity is one of the reasons we perceive very little inflation in spite of policies designed to promote it.

With the notable exception of live entertainment, goods and services delivered today are produced by fewer individuals and generally with less capital investment. It still takes more than seventy highly skilled musicians to perform a symphony from Tchaikovsky, the same as it did 150 years ago. No productivity gains will reduce the number of people needed to dance The Nutcracker. However, 120 years ago nearly 70% of the US population lived and worked on farms, and today that number is less than 2%. The amount of human and financial capital freed to pursue other endeavors due to technological innovation should continue to grow. If it does not, we will experience the serious problem of slowing growth and rising inflation, a situation last seen during the 1970s.

Today, we see the risk/reward proposition for equities as fair with an expected annual return in the 6-8% range. The outlook for bonds continues to be challenging due mainly to our current starting point. In spite of the Federal Reserve raising the Fed Funds Rate 1% over the last 18 months, rates are still at very low absolute levels. This, coupled with tight credit spreads (the premium one receives for loaning money to a company versus the government), is not a recipe for great returns. If everything goes well, investors will make a little money and, if not, there is a risk for poor returns from spreads widening and/or rates rising.

Many attractive investment opportunities within commodities and real estate are private and longer-term in nature. Hard assets are highly cyclical and tend to benefit from higher levels of inflation. Thus, the current environment is difficult. We expect returns similar to that of equities from this category for those that are patient and comfortable with the illiquid nature of these investments.

The best way to treat risk is to first understand how you define it, size it appropriately, and then monitor it diligently.

We wish you a wonderful summer season. Please reach out to continue the conversation.